Thursday, July 29, 2010

CVS-Aetna: Less Than Meets The Eye?

On Tuesday night, CVS Caremark (NYSE:CVS) announced a 12-year contract to provide PBM services to Aetna (NYSE:AET). Here is the official press release: Aetna Awards Long-Term Contract to CVS Caremark to Provide PBM Services.

First, the upbeat spin.
  • This is a bold move by CVS Caremark with enough positive strategic implications that it overshadowed the otherwise gloomy news from Q2 earnings.
  • The contract supports my contention that there will be more PBM consolidation ahead. Scale matters in the PBM business, especially on the eve of major generic launches.
  • It’s a great defensive move. Medco was rumored to be wooing Aetna last year, but now must shop elsewhere.
  • The size of the deal will relieve pressure on CVS Caremark as it fixes the PBM business.
Yet, I have some nagging doubts. The deal seems much more like a very big administrative contract win rather than a game-changing consolidation. The transaction is neither as straightforward as the Express Scripts/NextRx combination nor will it be as profitable for CVS Caremark. The lack of detailed financial disclosure also makes me wonder how much CVS Caremark was willing to concede to make it all happen.

Plus, CVS Caremark is embarking on a long-overdue consolidation of its multiple PBM platforms while simultaneously ramping up the Aetna business, adding implementation risk.

As always, I recommend that you can get the spin directly from each company's management on their respective earnings conference calls:

A big question: Does this arrangement finally “prove” the value of an integrated PBM-Retail model? Dow Jones states unambiguously: Aetna Pact Seen as Vote of Confidence for CVS Caremark Model and quotes numerous analysts to support this headline.

I’m not so sure. Much of the synergy in the CVS Caremark combination to date has come from (1) boosting CVS' retail pharmacy and (2) leveraging buying power against suppliers—generic drug manufacturers and drug wholesalers for brand-name supply. Scale will be crucial on the verge of Lipitor et al losing patent protection and the prospects for reduced per-script profitability on generic prescriptions.

The Aetna contract doesn’t seem to take advantage of Caremark’s broader array of Retail/PBM services.
  • CVS Caremark will be “managing purchasing, inventory management and prescription fulfillment” of Aetna’s mail order and specialty pharmacy. It will also provide administration of selected functions for Aetna's claim processing, customer service, retail pharmacy network contracting, and "physician engagement through e-prescribing."

  • Aetna will continue to control medical and pharmacy policy, formulary design, pharmacy/medical benefit integration, rebate contracting, and many other core PBM functions. Aetna is even keeping technical ownership of pharmacy licenses and clinical functions.
Watch this short video with Aetna Chairman and CEO Ronald Williams, who emphasizes that CVS Caremark will help Aetna “purchase much smarter for our customers” and “administer the benefit cheaper as well as buy smarter.” Hmmm. (Click here if you can't see the video.)

Fun fact: Aetna apparently spent $50 to $60 million on financial advisers, consultants and legal advisers to get the transaction executed. Sweet!


Despite the apparent similarities, this deal appears to be much less beneficial to CVS Caremark than the Express Scripts deal with NextRx. Express Scripts estimates an incremental $1 billion EBITDA (Earnings Before Interest Taxes and Depreciation) from the acquisition of NextRx’ $16 billion in drug spending.

The EBITDA benefit to CVS Caremark will be much smaller on Aetna’s $9.5 billion in drug spending since there will be less integration and cost cutting given Aetna’s retention of core PBM functions. My back-of-the-envelope calculations suggest the deal will generate an incremental EBIDTA per Adjusted Script for CVS Caremark that is 75% lower than the incremental EBITDA per script that Express Scripts will get from NextRx.

Nonetheless, the economics of the deal are still murky. Yesterday’s conference call raised as many questions as it answered. The Wall Street Journal’s Health Blog has a good summary in Analysts Question Aetna on CVS Caremark Deal.


McKesson will take a margin hit. As I discuss in The 2010-11 Economic Report on Pharmaceutical Wholesalers, the ongoing consolidation of the pharmacy industry will pressure wholesaler profit margins from drug distribution. The supply chain purchasing savings will come at the expense of drug wholesaler McKesson (NYSE:MCK), which supplies the mail pharmacies of both Caremark and Aetna. While there will be no volume movement between wholesalers because of the deal, CVS Caremark presumably buys at a bigger discount than Aetna, translating into lost margin for McKesson.

More evidence against the Transparency Myth. Independent pharmacies are lobbying for “PBM transparency” legislation that will purportedly help plan sponsors. Yet here we have an example of a large plan sponsor choosing to outsource a chunk of its PBM operations to an independent company. So, I presume NCPA will be contacting Aetna’s management to explain the foolishness of this transaction and how independent pharmacies know better than Aetna, right? (See Why do pharmacy owners care about PBM transparency? to understand why Aetna won’t take their call.)


Any bold reader care to share their analysis or predictions?


  1. AnonymousJuly 29, 2010

    As always, love your blog and read religiously. While ESRX's profitability on NextRx appears much better than the CVS deal with Aetna, remember that ESRX had to pay $4.7 BILLION for that privilege.

  2. My back of the envelope calculation is net of financing costs for ESRX. OW, the gap would be bigger.

    One analysis that I read pegged financing costs at a 30% hit on EBITDA/script for ESRX.


  3. AnonymousJuly 29, 2010


    Nice piece as always. This deal sounds to me like CVS making a statement: we are in the PBM business for the long haul. Has this deal changed your opinion with respect to CVS and Caremark splitting up? What would a break up mean in the context of the deal?

  4. AnonymousJuly 29, 2010

    Love the site Adam! How would you compare the Aetna/CVS deal with the UHPS/Medco arrangement?

  5. AnonymousJuly 29, 2010


    Good post. But did you just have to throw a zinger at independent pharmacies at the end ???

  6. Another timely post Adam. As usual, nicely done! Two thoughts come to mind regarding your comments regarding scale:
    1. Since we don't get to see the contracts with wholesalers, the assumption is that Caremark will be able to extract larger discounts. I have heard that this may not be the case; and
    2. If they do receive bigger discounts, the improved margins accrue to the benefit of Caremark shareholders, not PBM clients. The impact of scale depends on which constituency one represents.

    It's not the price at which PBMs buy that makes a difference; it's what they are willing to pass-through. Many public PBMs can't/won't sacrifice their earnings call in order to give clients a better deal.

  7. Mike StocklessJuly 29, 2010

    Nice post.
    The competitive dynamics in the drug distribution channel is amazing. I haven't seen any other industry more convoluted in that respect.
    The economic benefit of the deal is dismal for CVS who will only earn 10 cents a share after the plan is fully implemented. That works to around a dollar a share in the life time of the deal.
    With these kind of intense competitions between them the major PBMS are no longer a sure bet for your investment dollars as they were in the last decade.

  8. AnonymousJuly 29, 2010

    As always some good content, but why always negative on CVS? If I gave you the chance to buy one stock in this industry, which one would you buy? I'd take CVS, no hesitation, over any of the drug manufacturers, retailers, pbms, or insurers. Poor independents, I own one, and only made 800k last year. Bummer.

  9. I wrote "I presume NCPA will be contacting Aetna’s management to explain the foolishness of this transaction and how independent pharmacies know better than Aetna." Some of you felt that this comment was gratuitous.

    Well, looks like I was even more prescient than I could have predicted. Here's a quote from the National Community Pharmacists Association's "Statement on CVS Caremark-Aetna Agreement:
    "Aetna customers and patients can anticipate a barrage of misleading sales pitches and complex schemes intended to camouflage CVS Caremark's history of over-promising and under-delivering on pharmacy savings."

    Gee, NCPA really does know better than Aetna!


  10. AnonymousJuly 30, 2010


  11. AnonymousJuly 31, 2010

    Lets think of the retail impact to WAG.

  12. Re:Walgreens

    More Maintenance Choice = Bad for WAG

    MC pushed CVS’ same-store pharmacy sales growth above Walgreen’s growth starting in early 2008. See the chart in CVS Grows While Legal Storm Clouds Gather.

    Just keep in mind that Aetna plans could have chosen MC even without this agreement. The benefit design decision is ultimately made by the the plan sponsor, not the PBM. Many critics of CVS Caremark fail to understand this fundamental point. See Pepsi, CVS Caremark, and the FTC.


  13. Adam thanks for your input on MC.

    Also think about this, with the recent WAG v. CVS showdown regarding reimbursements, we learned that CVS aggressively MAC'd WAG. If CVS is managing Aetna's prescriptions filled at WAG, they will aggressively MAC these prescriptions as well. Essentially, WAG's current AET prescriptions should see margin erosion.

  14. Anonymous said...
    Adam thanks for your input on MC.

    Also think about this, with the recent WAG v. CVS showdown regarding reimbursements, we learned that CVS aggressively MAC'd WAG. If CVS is managing Aetna's prescriptions filled at WAG, they will aggressively MAC these prescriptions as well. Essentially, WAG's current AET prescriptions should see margin erosion.

    Hopefully by then there will be more transparency and better rules to prevent CVS from continuing to single out a competitor through their PBM offerings. I think Microsoft got in trouble for something similar. :)

  15. CVS is hoping for more Rxs their way with the AETNA Rx cards saying CVS/Caremark (which is good for market share). Aetna is (possibly) hoping for better price control - and/or "trusting" that CVS is offering them the BEST price for all of the Rxs (including generics) while CVS is looking for Rx count (which has NOTHING to do sometimes with "bending the cost curve in healthcare") and AETNA can brag to its employer groups (who ultimately pay the price for premiums and coverage) that they are "doing something". The losers here are the employers who trust this as being good for them and the end patients who will naively assume that they can ONLY go to CVS for their Rxs as that is what their benefits say.

    I prefer the WMT model of going direct to the employers and having a truly cost plus approach to Rxs and also PUSHING generics by COST to the end user- the patient. I don't see anything in this model to motivate "change" for the consumer that will in the long run make them healthier and possibly need LESS Rxs (and utilize LESS benefits) in the process.